~ Investment Strategy

Why are Spanish yields still rising? Is it something to do with the fact that foreigners are leaving the market? Aren’t they being replaced by ECB inflows?

OK, let’s make a model. Imagine a Walrasian auction (http://bit.ly/QsiOlH) in which there are three groups: government, locals and foreigners. The only financial assets in the economy are standardised government bonds. Government sells a given number of bonds in each period. Locals and foreigners may buy or sell bonds depending on their individual preferences which are not determined by their group membership. The situation looks like this:

Sellers:
Government
Some locals
Some foreigners

Buyers:
Some locals
Some foreigners

Let us assume that in the first period, the market clears at a price that doesn’t make everybody worry. Now let’s consider the effect of capital flight. For whatever reason, foreigners decide to exit the market. The situation looks like this:

Sellers:
Government
Some locals
All foreigners

Buyers:
Some locals

If local holdings of government bonds are high then prices are likely to fall a long way. But now let’s think about the ECB. Foreigners’ exports of capital from Spain are replaced by the Bank of Spain (lending directly to Spanish banks). Let’s incorporate this into the model as “ECB” (of course, it is not actually the ECB that buys, but some locals, financed by the ECB; I have have labelled the extra local demand for bonds “ECB” because that is where the money has come from).

Sellers:
Government
Some locals
All foreigners

Buyers:
Some locals
ECB

Because of the way that TARGET2 works, ECB should exactly offset All foreigners, other things being equal (this is why Spanish yields have not had a massive spike). Thus the situation reduces to this:

Sellers:
Government
Some locals

Buyers:
Some locals

So why are Spanish yields rising? In the model, it must be because locals’ preferences have changed in such a way that the market clearing price for bonds has fallen. Why has this happened? For local banks, I think the funding model is the best explanation: banks do not have secure long-term funding and require extra yield to compensate them for their extra funding risk. For other locals, fear of mark-to-market losses might be a good explanation — because of potential contagion from the Greek situation, the Spanish banking bailout potentially inserting a tranche of senior debt, the deterioration in the Spanish economy, and so on. An improvement on any of these fronts ought to improve the situation, although the fact that yields did not fall following the Greek election suggests that it is the banks, rather than other locals, that are most important here.

How can Spanish yields be reduced, then? It must be by inducing the banks to purchase Spanish bonds, either by giving them secure funding — like a 3-year LTRO — or by signalling that their funding costs will remain low, which could be achieved with QE, or with a commitment by the ECB to keep rates low for a specified period and to continue to conduct shorter-term refinancing operations on a full-allotment basis. Thus the ECB could solve the problem, if it was minded to do so. One might also give banks access to secure funding by reopening the private market for the senior debt of Spanish banks. A necessary condition for this will be giving the banks adequate capital — something that is happening; it would also be helpful if the governments of the Eurozone were to provide some kind of guarantee for the senior debt of Spanish banks.